Definition:
Outsourcing
from The AMA Dictionary of Business and Management

Contracting out work to foreign or domestic companies for the production of materials, spare parts, or services such as telemarketing. This is an effort to reduce the workforce or downsize a company's production facilities, invariably leading to considerable savings, especially when the work is outsourced to countries like China and India where labor costs are lower. The downside is that outsourcing leads to or reinforces domestic unemployment and creates dependence on foreign expertise. It also leads to a general weakening of industrial dominance in the countries that outsource.

The trend to source out internal functions to foreign corporations and locations has experienced strong growth over the past decades and has accompanied the expansion of global trade and investment. Outsourcing has led to a new pattern in the international division of labor between the industrialized and the developing nations. It has largely contributed to the economic success of emerging countries like India, Taiwan, and China. Outsourcing is influenced by a bundle of different macroeconomic and business-related factors. After decades of expansion, the trend to source out value-added goods and services, however, seems to have peaked.

What Is Outsourcing? Definitions and Theoretical Foundations

One of the most common definitions of outsourcing is provided by Richard Chase and colleagues,, and it refers to outsourcing as an “act of moving some of a firm's internal activities and decision responsibilities to outside providers.” Outsourcing can be defined as a strategy or decision of a corporation to use external sources and buy a part of the goods, such as resources, intermediate input goods, or semifinished and finished goods or services, from an external firm at a different location. Thus, outsourcing implies that the production processes of goods or services are split up between several firms, often internationally. The producer or contractor abroad can be vertically integrated into the corporation via foreign direct investment, wholly owned subsidiaries, and other governance forms, based on ownership and equities. The foreign partner firm may also be a contractual partner of the outsourcing firm through short-term market contracts, like export/import contracts, or through long-term collaborative arrangements, such as subcontracting agreements, franchising, or licensing contracts. Some narrow definitions view outsourcing solely as a collaborative or contractual agreement between independent firms, while other authors also include interfirm relationships in their definitions, which are based on ownership and equities that the outsourcing firm holds with the foreign partner. Outsourcing is closely associated with the internationalization of production and firms. Thus, it is discussed in the economics literature (mainly in international trade) and by management scholars (e.g., in strategy, human resources management, and organization theory).

Benefits

The decision of a firm to outsource can be illustrated using Oliver E. Williamson's transaction cost theory and agency theory. Transaction cost theory claims that a firm needs to decide on whether to produce certain goods or services internally or in-house (make), or seek external sources through market contracts and other arrangements (buy). This decision is based on the degree to which comparative transaction costs are incurred. The basic make or buy decision can be applied to the strategy of a corporation to outsource part of its production process to a foreign firm.

Outsourcing offers transaction cost benefits when the sum of search costs for suppliers, asset-specific investments like technically advanced facilities, skilled or trained manpower abroad, and contract costs is lower than the cost advantages that would occur with in-house production. From a theoretical viewpoint, a firm should also consider potential information asymmetries between the contractual partners or between the outsourcing firm and its workforce abroad—for example, when the performance of foreign labor cannot be fully controlled or anticipated and lower efficiency or productivity might result from this information bias. In addition to the agency and transaction cost theories, the resource-based view theorizes outsourcing as a value-generating strategy using interfirm relationships and networks, where specialized resources are provided externally. In international economics, trade liberalization through outsourcing, global trade, and investment is typically associated with welfare gains at the society level. However, this view has been challenged, and researchers are investigating the effects of outsourcing on employment and welfare in industrial nations because many practical cases have shown that outsourcing implies job losses and rising unemployment at home.

Related concepts and terms are offshoring and supply chain or value chain management. Offshoring means to outsource internal functions to a foreign location, while retaining ownership and control through foreign direct investment or majority-owned subsidiaries. The discussion about offshoring is often associated with the migration of internal functions and jobs from high-wage to low-wage countries. Outsourcing and offshoring are thus closely related terms in the context of global production and international division of labor. Supply chain or value chain management is associated with the management of complex, globally organized value chains, ranging from sourcing of inputs to production, sales, distribution, and after-sales services for the final consumers. Firms are increasingly considering outsourcing as a suitable strategy for managing supply chains for goods and services that are produced for global markets. Recently, reshoring and nearshoring have emerged as related concepts: Reshoring means reshifting parts of the value added in the production process back to the home country, while nearshoring refers to shifting value-added functions to a foreign location with strong cultural or economical similarities to the home market.

Enabling Factors of Outsourcing

The rise of outsourcing as a business model for many large corporations and industries has been made possible by several interdependent factors. Technological change from steadily dropping information and communication technology costs reduced the distances between firms, making it possible to interact across the globe, and allowed for more efficient ways of communication, information, and service provision. With trade liberalization through new WTO (World Trade Organization) agreements between the industrial nations, developing, and emerging countries removed trade and investment barriers and transportation costs for firms operating in the global marketplace and opened the markets for production factors and goods across the globe. Many firms began to strategically utilize cross-country differences in production costs and wages to maximize their profits and seek cost efficiency.

Besides large corporations and global players, small- and medium-sized firms from both the industrial and the emerging nations have benefited from the ongoing and accelerating globalization. Thus firms, irrespective of their size, are increasingly using outsourcing as a business strategy for staying competitive in their home and export markets. Many industries are now integrated into the global supply and value chains, with large shares of subcontracting and outsourcing provisions. Automotives, electronics, textiles and clothing, information technology (IT), health services, and book publishing—all these industries are now ­globalized to a high degree and involve many ­different outsourcing contractors and interfirm networks across the world. Because of the growing significance of interfirm networks and global value chain integration in many export-based ­sectors, firms have to consider global sourcing, production, and outsourcing strategies to keep their competitiveness in the global marketplace.

History

The concept of outsourcing can be traced back to Adam Smith, who discussed the fundamentals of international trade and the division of labor between countries. In the context of globalization, outsourcing activities have been on the rise since the 1980s to the 1990s. Originally, firms started using outsourcing and offshoring for functions that were regarded as peripheral to the production process. These noncore activities were more or less standardized and disposable services like maintenance, cleaning, catering, or security. Often, outsourcing also included more sensitive areas where skills and know-how were paramount to the competitiveness of the outsourcing firm, including design, marketing, distribution, after-sales services, and information systems. Over time, many corporations with global trade and production linkages began to shift their core activities (complete production units and research and development facilities) to external providers, because of rising competition at the global scale and the growing importance of global value chains. The migration of core functions like production facilities to offshore locations has been criticized because it often implies the rising unemployment of unskilled workers in industrial nations.

The first wave of global outsourcing and offshoring took place in the manufacturing sector because firms were seeking to mass-produce goods at lower costs and benefit from economies of scale. Outsourcing first appeared in the electronics, automotive, textiles and clothing, and apparel sectors, where the production process can be split up into separate components or assemblies that can be produced in geographically distant places and easily transported back to the country of origin. For example, the European textiles and clothing sector started to migrate production facilities and jobs from northern and western Europe to low-cost locations in southern Europe in the 1970s to the 1980s; this shift accelerated over the following decades, with facilities and workplaces moving from southern Europe to eastern Europe in the early 1990s and later on to Asian countries. Many American corporations, and later European firms, saw the need to improve their competitiveness with the rise of Japanese competitors and their “lean production” model in the 1980s to the 1990s.

Later, outsourcing also became an important business strategy in many service industries, benefiting from dropping information and communication technology costs and new technologies. Outsourcing of IT and customer services like information processing, bookkeeping, payroll services, and call centers became a major trend in the 1990s to the 2000s. Important global corporations like Eastman Kodak and IBM outsourced their IT processes or other service departments and thus set the standard for many global corporations in the early 1990s. Over time, India became an important target market for large-scale outsourcing and offshoring of IT and business processes by American and European firms. In Ireland, the Celtic Tiger benefited from the service and from outsourcing of IT by American and European corporations to the northern European country.

Current Situation

Currently, outsourcing and offshoring at the global scale have seemingly peaked. Large corporations are taking back production facilities to their home countries, as the recent cases of General Electric or Ford Motor Company in the United States illustrate. Moreover, investors from emerging nations like China are increasingly using locations in industrialized nations for their overseas production and customer services sites. This is the case with the Swedish-Chinese automotive company Volvo—keeping its Swedish production and research and development sites at their former locations—and the U.S. investor Lenovo, a computer manufacturer in North Carolina. One important reason for this move back is that the wages in emerging countries like China and India have been rising in the course of the economic upgrading of these nations. Consequently, high-wage countries regain competitiveness, and the wage gap narrows as compared with the previous decades.

Many companies are also becoming aware of the low innovative capacities of their offshore locations, especially when research and development facilities have migrated, and thus seek to concentrate on their core competencies, which are necessary to generate innovation, in the home market or at nearshoring locations. In addition, the image of emerging nations as low-cost locations and providers of cheap workers has markedly changed. For example, the German car producer Volkswagen nowadays mainly views China as a huge market to sell small and executive cars to the growing cohort of middle- and upper-class consumers. Firms from the industrial nations have thus started to apply mixed strategies, and they consider the former low-cost emerging nations as large markets for both inputs and final goods or services, and strategies solely based on labor cost savings have decreased in importance.

In turn, many contractors from the emerging nations have gained experience and are using the knowledge gained through outsourcing partnerships and global supply chains to upgrade their production and become competitive in global markets with their brands. A famous case in point is the Taiwanese computer manufacturer Acer, originally an equipment producer and outsourcing partner of IBM. Acer managed to upgrade to a computer producer with a strong brand that now ranks among the top five computer brands worldwide. Despite these general trends, global outsourcing will remain an important future strategy for corporations to enhance their competitiveness in a globalized world. According to a recent survey of the consulting group Ernst & Young, European corporations are planning to rely on IT services and business process outsourcing to enhance their competitiveness in the future.